b-2. Is the market's expectation of the return on the 3-year bond greater or less than yours?
Greater
Less
a)
Current year yield on a 3-year bond = 8%
Face value = $100
Current price of 3-year bond = $100 / 1.08^3 = $79.38
After one year, this 3-year bond shall be a 2-year bond having 2 years to maturity. Next year yield on a 2-year bond is 8%.
Price of 3-year bond next year = $100/1.08^2 = $85.73
Expected rate of return over coming year = ($85.73 - $79.38) /
$79.38
= $6.35 / $79.38
= 8%
Expected rate of return over coming year = 8.0%
b)
Forward rate for 2-year bond = (1.07^2 / 1.06) - 1 = 8.01%
Forward rate for 3-year bond = (1.08^3 / 1.07^2) - 1 = 10.03%
Forecasted yield for 1-year bond = 8.01%
Forecasted yield for 2-year bond = (1.0801 * 1.1003)^(1/2) - 1 = 9.01%
c)
The market forecasted return is higher than the our forecast.
b-2. Is the market's expectation of the return on the 3-year bond greater or less than...
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